KTOS - Kratos Defense & Security Solutions Is Taking-Off

2023-05-21 05:43:50 ET

Summary

• Kratos Defense & Security Solutions sells into a highly desired, well-funded segment of the Department of Defense.
• After an acquisition spree, Kratos is transitioning to basic financial health improvement fundamentals that can potentially drive up the price of shares.
• Analysts and shareholders are enthusiastic and Seeking Alpha raised its Hold assessment to a Buy when the price slipped under $14 per share.

Best Offense is Strong Defense

We have been bullish on companies in the defense and aerospace industry for nearly a decade. This essential industry enjoys annual budget growth worldwide. In America, the industry supports about 2M American jobs, and, on average, pays wages and benefits 41% higher than the national average. Dominated by behemoths, there is, nevertheless, plenty of room for others. Governments and commercial ventures nurture start-ups and specialty niche small businesses like Kratos Defense & Security Solutions, Inc. (KTOS).

As of 2021, the latest data for Aerospace and Defense Applications Market Shares Split By Top 10 Aerospace and Defense Vendors and Others

According to The Business Research Company's latest report , the industry is growing at an annual CAGR of 7.6%, as of 2022.

Some Numbers

Kratos Solutions stock had a flat year (+0.71%). After hitting bottom ($8.91) last winter in anticipation of a disappointing FY '22 and Q1 '23, the share price climbed to a recent high of +$14. The share price is on target to reach its 52-week high of $16.23; it is likely to top it on news of higher earnings later this year. The average price target among the few analysts following Kratos is over $16. We foresee it closer to $19 based on higher defense spending on drones and aerospace. The stock gets high Factor Grades from SA in momentum and growth.

The Factor Grades now are higher than in past months' assessments. Short interest is just 2.07%. The Beta rating is a reasonable 0.82. Wall Street and SA analysts appraise the stock as a Buy. SA's Quant Rating assessment was rated a Hold as of last week but leaning to the Buy-side. SA upgraded Kratos assessing the stock worth a Buy consideration, as the share price slipped to close under $14 by May 19. The company in our opinion offers low risk for retail value investors, though there is no dividend.

Kratos is not as strong financially as other defense and aerospace companies we spotlighted in our Seeking Alpha articles . Despite current risks and past difficulties, the stock is positioned for a move up. These are the company's specialties:

The Company

Kratos Defense & Security Solutions, Inc. is 11 years old. It operates through two segments, Government Solutions and Unmanned Systems. It contracts for equipment and services with domestic and international security agencies, the Department of Defense, intelligence agencies, and commercial customers.

Revenue and earnings steadily increased over the past few years. The last quarterly earnings report, Q1 '23, was disappointing, but the consensus is future quarters will be better. FY '23 is forecast to report an EPS of $0.21 to $0.29, FY '24 between $0.34 and $0.41, and FY '25 around $0.46. In sum, in Q1 '23, revenue of $231.8M was an 18% increase over Q1 '22 revenue of $196.2M; there was organic growth of 12%. Operating income was $0.5M, producing a net loss of $7M. The adjusted EBITDA was $17M. Included in first quarter net loss and operating income is non-cash stock compensation expense of $6.6M million and company-funded R&D expense of $10.2M.

Past Is Prologue

Three times in the Q1 '23 SA transcript of the earnings call, management tells shareholders and analysts that 2023 is a…

...transition year to expected sustained future year-over-year organic growth, increasing profit margins and cash flow… We transitioned from development to production and delivery… Our revenue mix continues transitioning from older firm fixed price contract where we were enabled to pass on significant inflation and increased costs to newer more recent contract award related revenues, where we negotiated higher rates and costs with our customers…

Future earnings and revenue estimates stemming from this newer approach are sparking the stock's momentum:

Headwinds Can Be Risks

Three headwinds are pronounced. First, the company built $352.6M of debt. It holds $328M in receivables and ~$59 in cash and equivalents. Kratos acquired 15 companies, 3 in the last 5 years. 24% are in defense and 16% are in aerospace. Add into the stew pot $234.2M of liabilities due within a year, and another $369.8M due further into the future. Liabilities total are more than cash and receivables. EBIT fell 83% last year; combined with rising interest rates and tighter credit, investors need to keep a close eye on the balance sheet. If you believe the transition will be fruitful, then the company can potentially come out from under the debt burden.

Second, the challenges faced by negative operating and free cash flow can be a risk.

Third, corporate insiders have been selling many more shares since last September than they bought. Hedge funds too decreased holdings by 125K shares last quarter. 22 funds owned shares in Q1 '22, but only 18 owned shares a year later. 81.5% of the shares are owned by institutions and 2.15% by insiders.

Takeaway

If a small investor has a high-risk tolerance to see it through to the transition era, we think the stock is worth considering a moderate buy. Drones and aerospace are the bread and butter of Kratos Defense & Security Solutions, Inc. The DoD budget is going up to outpace the defense spending of China and drones and aerospace are the priorities; they call it the "pacing challenge." Kratos has the potential to greatly benefit, but management has to focus on the basics, i.e., cutting debt, improving earnings, and increasing free cash flow.

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